TSC Options Forum: Vega the Greek

I've had a most disheartening experience with a spread I had purchased in AMR(AMR) in November at $7.50 to $10. Back in early May, I decided I wanted to get some exposure to this volatile stock. I decided to go for a spread as a more conservative method. Imagine my dismay when I find that the recent run has only brought me to even on a net profit basis! After checking the "greeks," I was even more horrified to find that the difference in delta between the calls is minimal and that the vega even suggests that an increase in volatility will work against me. I could have doubled my money had I just gone with the "naked" long!

Could you discuss these additional nuances on your profit potential on a spread? Thanks. -- D.A

One of the most frustrating things about trading options, aside from wide spreads and illiquid markets, is when your thesis is right but the option strategy employed yields disappointing results. This question provides a great opportunity to drill further into last week's discussion of how to choose the appropriate weapon in your options arsenal when establishing a position.

Options can be a double-edged sword in that while they provide leverage and a price cushion, they can also dampen returns. This is the continual tug of war between using options as a purely speculative vehicle or as a means to reduce risk. In order to realize maximum benefits both are dependent on a very specific set of scenarios aligning with the appropriate strategy. And even then, sometimes it's better not to use options at all. (More on when less is more later in this article.)

I Was so Right but Feel so Wronged

I don't exactly know what D.A. expected to occur with AMR's stock, but I can make a reasonable inference: He was looking to establish a bullish position on the belief that the troubled airline was poised for a sharp bounce.

The key here is the sharp bounce and mention of volatility. A vertical call spread is indeed a bullish position, but it isn't the most effective means of capturing a rise in price or an increase in volatility. This brings us to vega, one of the "greek" measurements (like delta and gamma) that compare an option's price sensitivity with different factors. Vega has a justified reputation for being infuriatingly unpredictable, but something for which we're better off having made its acquaintance.

Vega is defined as the expected rate of change in an option's theoretical value for a one-unit change in implied volatility. Simply put, if you expect an increase in volatility, you want to get long vega. The most straightforward way to achieve this is to own a greater number of options than you are short.